Wednesday, November 14, 2018

A Tale of Two Hotels

"Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable;
The result is certain – unremitting woe!
And I hear the banker utter an ominous low mutter,
‘Watch cash flow’.”
            -Herbert S. Baily, Jr.

“Money often costs too much.”
            -Ralph Waldo Emerson

Part I: A Brief History & Overview
In 2013, Hilton Worldwide went public after having been under private ownership by Blackstone since the late 2007. Earlier this year, Blackstone exited their position in Hilton Worldwide completely. Bloomberg is calling it “the best leveraged buyout ever.” Back in 2007, Hilton Hotels Corp CEO, Stephen Bollenbach, said that the decision to have Hilton bought out by Blackstone would be the best opportunity to “maximize shareholder value.” Of course, history has told us that a leveraged buyout is never done because a business is doing well, so “maximizing shareholder value” was merely a guise for something more ominous.

Hilton’s last annual before the buyout, 2007, shed some light. While operating cash flows on the surface appeared to be very positive and growing ($548M, $486M, and $652M in 2004, 2005, and 2006 respectively), it was line items in investing and financing activities that gave cause for concern. Proceeds from asset dispositions were providing unsustainable cash flows ($1B in 2005, $1.45B in 2006), and borrowings, while they didn’t play much of a role before 2006, were ramped up to $2.6B during 2006. There was also a $1.5B increase in revolving loans.
But there was one item in particular that was waving a red flag: an enormous $5.46B outflow of cash in investing activities from an acquisition. Let me say that again: five and a half billion dollars. That’s nothing to sneeze at.

In the footnotes, Hilton’s management warns us in one line: “We are more highly levered as a result of the HI acquisition.” During 2006, Hilton Hotels Corp (what Hilton Worldwide was called back then) acquired Hilton International. Farther back into the footnotes, we find that because of the HI acquisitions, Hilton Hotels entered into new senior credit facilities, from $1B to $5.75B like the drop of a hat. A 2007 news article further mentions that Hilton’s indebtedness was financed with $20.6B of mortgage and mezzanine debt financing.

This acquisition was the hay barrel that broke the camel’s back. Not soon after, Blackstone started showing some interest in Hilton, and the rest is history.

It was Mark Twain who once said, “history doesn’t repeat, but it does rhyme.” This time around, the demise will be more subtle as debt payments begin to creep up in the coming years. Unless of course, Hilton Worldwide decides to do just one more “diworseification.”

Before I get into the details, just upon first glance, we already see comparisons to Hilton Hotels in 2006/7. Earnings to fixed charges in 2004-2006 were 2.2x, 3.1x, and 2.3x respectively. In 2018, EBIT covers interest a measly 3x, roughly the same as it was before. In most respects, the Hilton situation is a replica of 2007 Hilton, with a little more cash on the balance sheet. But what’s $500M really when you’re up against billions in debt?

Part II: Cash Flow Analysis – Past & Present
I’ll be analyzing Hilton’s cash flow in two ways: the first through a multiple-year excess cash margin, and the second through a detailed multiple-year FCF worksheet.

An excess cash margin analysis compares the growth rates in earnings and operating cash flow. ECM declines when operating earnings grow more quickly or decline more slowly than operating cash flow.

What I’ve done above is adjust reported operating cash flow and operating earnings for non-recurring and non-operating items. By subtracting the two, and dividing by revenue, I can see how it trends. It’s not about it being negative as much as it is about how negative it gets. By 2006, ECM declined had declined from -4% to -7%, which is almost double in three years. What this means is that earnings were growing much faster than operating cash flow. We can see similar trends happening today. By 2017, ECM was -9% from -5% in 2015. Looking at adjust OCF, it almost halved between 2016 and 2017, while adjusted earnings increased slightly. The takeaway from this is that it tells us that we should look further. There’s probably a cash flow problem somewhere.

To pinpoint where, we look at FCF detailed over the three years.

In this version of deriving operations cash flow from 2004-2006, we see an almost identical trend to reported operating cash flows: positive and increasing. Cash flow after debt service doesn’t look much different either, except for 2006. The highlighted LT debt line shows a sudden $1.3B cash outflow, which causes 2006 cash flow to venture into negative territory where it stays before external financing. Now here’s the kicker. After external financing, cash flow is suddenly out of the hole and a positive $2.3B, all thanks to LT debt financing (a.k.a. increased senior credit facilities). Despite the artificial financing, the HI acquisition knocks cash flow back into the hole, $3.1B deep. So, the trend we see in the end is positive and growing, up until 2006, when the pendulum swings and breaks from the acquisition, which can’t be covered, even by financing.

The past is the past, but how similar is it to now? Below the spreadsheet shows operations cash flow from 2015-2017. The trend is flipped, from negative in 2015 and 2016, to positive in 2017, which different from what is reported on the cash flow statement. As you can see, LT debt payments are substantially bigger each year than they were in the mid 2000s period. Cash operating expenses, of which half consists of other expenses from franchises and managed properties, is 4x what it was in 2004-2006. It appears that cash flows are substantially more negative this time around, dragged down by LT debt payments: -$1.6B in 2015, -$4.4B in 2016, and -$1.9B in 2017. External financing did little to help in all years. The acquisition in 2015 (related to Park Hotels spin-off) shows just how dire the situation can get with cash after acquisitions -$3.4B. Hilton Worldwide appears to be teetering on the brink of solvency according to this model, and it’s only a matter of time until the credit markets dry up and leave little room to fund existing debt with new debt.

Part III: The Marriott Dis-analogy
Upon re-reading You Can Be a Stock Market Genius, it became very apparent that Hilton Worldwide since 2015 may be the complete opposite of Marriott back in 1993. Marriott International spun-off Host Marriott towards the beginning of what would become a 10-year expansion. Hilton Worldwide spun-off Park Hotels and Hilton Grand Vacation at what may be the end of a 10-year expansion.

In 1993, Host Marriott received all of Marriott International's debt and the headache of hotel properties while Marriott International got the lucrative management fees with very little debt (most of which was structured so that it was convertible into common equity).

Despite being left with consistent revenue streams from management & franchise contracts, the parent, Hilton Worldwide has still managed to burn through half its cash on the balance sheet within a year, and is loaded with long-term debt (roughly 7.7B as of the most recent quarter).

What was the most surprising about Hilton’s spin-off deal was the management didn’t completely palm off their debt to the spinoffs. The company still has tremendous leverage. On the other hand, Marriott made the smarter decision back in 1993 by transferring most, if not all, of their debt onto Host Marriott.

Part IV: Macro Implications
There has been a noticeable weakening of loan covenant quality since after the credit crisis of 2008. Most characteristic is the issuance of covenant-lite levered loans. In 2010, these loans represented less than 20% of the loan market. In the midst of the boom (2006 and 2007), they were 25%. In 2018, covenant-lite loans make up approximately 77.6% of the loan market.

Demand for floating-rate leveraged loans will lead to more defaults and lower recovery rates in the next economic downturn. The prevalence of senior loan-only structures, like we see, for example, with Hilton Worldwide, is that it lacks the cushion of junior debt. Moody’s has even hypothesized that this could produce an extended default cycle. $891B of US leveraged loans were issued as of mid-August, 2018. This was higher than last year’s record of $833.7B during the same period. In addition, B-rated loan volumes totaled $39.1B through mid-August, up 90.7% from 2017. Hilton is among them, having their senior notes rated Ba1 by Moody’s.